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Thursday, February 21, 2008

When is the Right Time to Buy a Stock?

ABC stock has been rising steadily lately – is this a good time to buy? XYZ stock has fallen steadily lately – is this a good time to buy? Sadly, the answer in both cases is maybe.

It turns out that you just can’t tell what is going to happen to a stock by just looking at what has happened in its price history. ABC might go up and it might go down. The same is true of XYZ.

To understand this better, let’s look at an example that is much easier to understand: bananas. Suppose that bananas have been selling for a dollar per pound. Sometimes you buy a few and sometimes you don’t.

Suddenly, banana prices jump to $1.50 per pound – should you buy them now? If the bananas seem the same as usual then probably not. But what if the bananas look unusually good, and you ate one and found it to be much better than the usual bananas? Then you’d probably buy them at the higher price.

The next month, banana prices drop to 50 cents per pound – should you buy them now? If the bananas seem to be about the same quality as you’re accustomed to, then you’d probably buy more of them than usual. But what if they are overripe and bruised? Then you probably wouldn’t buy any at the lower price.

In both the price rising and price falling cases, we couldn’t say for sure whether we’d buy bananas until we knew more about their quality. The same is true of stocks. You must have an opinion about the prospects of ABC company’s future success to decide whether to buy the stock. This is true regardless of what has happened to the stock price lately.

If you don’t know how to go about forming an opinion on the future prospects of a business, then you are a good candidate for investing in a low-cost equity index fund. This way, you’ll get the market average instead of being like most investors who get less than the market average because they pay high fees or try to time the market.